On the Eve of Draghi’s Reckoning, Risk Is Mispriced

Today’s FOMC meeting passed uneventfully and without consequence. Given stocks’ behavior throughout this week, we saw the probability of immediate Fed intervention drop to near zero. Then, the FOMC affirmed a zero probability today. Now, what S&P 500 (SPX) gains remain since the July 26 rally not only control for Fed stimulus, but they also quantify the expected value of ECB intervention… effective immediately. Hence, all eyes are watching the ECB Governing Council, who convene tomorrow. Given the gravity of what comes from this meeting, the market’s ignorance of risk feels unusual.

Within two weeks of the 2011 high, I noticed the mispricing of equity risk, and SPX technicals led me to cash shortly thereafter:

“Fundamentally, I can’t resolve how there exists such uncertainty over the future of policymaking (e.g. government shutdowns, the end of QE2, the Fed’s succession plan and the quantifiable impact of its stimulus in the first place), yet VIX resides at a lowly 16 print. That price-range is below the historical norm, approaching modern record-lows. Perhaps we’re in a phase like 2006, where investors trust the Fed to support equity prices.”

Tonight, we face the same divergence between the market’s risk-on posture and investor’s professed anxiety. Recall the two catalysts that have carried the market higher in the past week: first, at the close on July 25 the Wall Street Journal’s mole, Jon Hilsenrath, leaked a story about proximate Fed intervention; second, on the early morning of July 26, Mario Draghi promised shock & awe intervention by the ECB. Since these events, everything has rallied–not just risk assets. SPX rallied more than 3.5% trough to peak. Upon realizing that the Fed wouldn’t act today, stocks spent this week retracing 70 bps of that move. SPX is still up 2.8% in only 5 trading days, for which we may credit Mr. Draghi. No other catalysts can claim responsibility for this bounce, hence that 2.8% move is the market’s expected value of ECB intervention–a probability weighted, time discounted input.

Maybe that’s not a huge expectation. Yet, recall that those announcements on July 25-26 rescued global markets from the brink, especially European markets. That suggests there’s a big downside were nothing to materialize at tomorrow’s ECB meeting. What does risk say about this conundrum? The Volatility Index (VIX) closed at 18.96 tonight. A VIX reading under 19 doesn’t necessarily indicate “low-risk” or “low-volatility,” but VIX with an 18-handle is, however, in-line with the low-end of the modern trading range. Similar to the SPX’s risk misrepresentation, VIX’s positioning seems inappropriate given the magnitude of the ECB Governing Council’s meeting tomorrow. Mr. Draghi gauged expectations himself:

“Within our mandate, the ECB is ready to do whatever it takes to preserve the euro… believe me, it will be enough.”

Tomorrow presents us with a binary event that I can model with a simple binomial equation: there are only two outcomes–positive and negative–for which each has a 0.50 probability. Knowing the backdrop, do these markets reflect the stakes? In fact, assign whatever probabilities you’d prefer. My point is, where has the [50%] risk of failure manifest?…

VIX weekly- 18.96 is not a low-risk VIX reading, but it’s in-line with modern lows–inappropriate given the magnitude of tomorrow’s European (in)action.

It’s manifest in sentiment. As aforementioned, investors’ “professed anxiety” is high. In fact, bearishness is at alltime highs according to Merrill Lynch:

This bearish sentiment makes a lowly VIX even more bewildering, as traders call VIX the “fear index.” That’s where institutional investors express their anxiety, using options to hedge positions.

Going into tomorrow, I’m positioned comfortably to weather the binary outcome. I don’t have to risk the gains we’ve enjoyed from licking the market’s curves so far this year. Our equity exposure has been trimmed down to just under 60% with the balance in bonds (mostly High Yield). Our Beta is running ~0.82. My best means of capitalizing on mispriced risk is cash or outright index shorting. I repeat, the VIX is a broken leading indicator. In fact, it’s a coincident indicator, and there are no suitable vehicles with which you may track it. (Not VXX, nor VXX.)

I do not expect the Eurocrats to have a packaged plan tomorrow. They will likely have another “plan for a plan,” some fancy new acronyms that disguise a shuffling-of-the-deck as would an illusionist. Perhaps underwhelmed at first, the market will ultimately applaud the magic of Keynesianism.

–Romeo

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[…] Wednesday. SPX decided to discount Fed intervention down to a zero probability, which led me to trim-down my risk exposure, taking equities to under 60%. Then, the market soldoff, underwhelmed by the […]

[…] All this market really wanted was affirmation that the Eurocrats were actually working toward solutions. Mario Draghi gifted such progress unto the market on Thursday, when he announced the ECB’s Outright Monetary Transactions (OMT)–the subject to his “believe me, it will be enough” predicate. […]